The yuan’s SDR entry is more symbolism than substance

Summary:
The yuan's official entry into the International Monetary Fund's basket of reserve currencies on Oct. 1 raised expectations that central banks all over the world would be scrambling to stock up on Chinese money. But the reality is far from that.
This op-ed was originally published in Nikkei Asian Review.
First, central bank purchases of yuan to comply with the Special Drawing Rights (SDR) basket are relatively tiny, equivalent to just billion. This is because even though the yuan is the third-largest currency in the SDR basket behind the U.S. dollar and the euro, with a nearly 11% weighting, the basket itself represents a very small part of foreign exchange reserves — just 0.3% of the global total.
Second, since the IMF’s announcement on Nov. 30, 2015, about adding the yuan to the SDR basket, central banks have had nearly a year to rejig their holdings to reflect the new allocations. This means the bulk of yuan purchases by central banks should have already taken place. Some data suggests that as much as 70% of central banks already had enough yuan to comply with the new SDR allocations even before the initial announcement last year.
Drawing power
The real question, then, is whether SDR entry will act as a catalyst for capital flows into China beyond the tiny required amount of yuan purchases.

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The yuan's official entry into the International Monetary Fund's basket of reserve currencies on Oct. 1 raised expectations that central banks all over the world would be scrambling to stock up on Chinese money. But the reality is far from that.

This op-ed was originally published in Nikkei Asian Review.

First, central bank purchases of yuan to comply with the Special Drawing Rights (SDR) basket are relatively tiny, equivalent to just $29 billion. This is because even though the yuan is the third-largest currency in the SDR basket behind the U.S. dollar and the euro, with a nearly 11% weighting, the basket itself represents a very small part of foreign exchange reserves — just 0.3% of the global total.

Second, since the IMF’s announcement on Nov. 30, 2015, about adding the yuan to the SDR basket, central banks have had nearly a year to rejig their holdings to reflect the new allocations. This means the bulk of yuan purchases by central banks should have already taken place. Some data suggests that as much as 70% of central banks already had enough yuan to comply with the new SDR allocations even before the initial announcement last year.

Drawing power

The real question, then, is whether SDR entry will act as a catalyst for capital flows into China beyond the tiny required amount of yuan purchases. In fact, even during the April-June quarter, when China’s foreign exchange markets calmed considerably from the previous three months, capital outflows reached $133 billion.

The figure for the July-September quarter was probably even larger. This means 2016 may end up being pretty similar to 2015 in terms of capital outflows, reflecting expectations of protracted yuan depreciation.

While some foreign investors may still want to tap the increasingly large onshore bond market and bet money within China, it seems unlikely that many will follow this trend at least until the People’s Bank of China reverses course and starts to move up benchmark interest rates. In the event of another rate increase by the U.S. Federal Reserve in the coming months, more attractive yields in China will become even more important to draw investors.

The tensions seen in the offshore yuan market in mid-September, with overnight interest rates to borrow yuan spiking, illustrate how little the market outlook on the Chinese currency has changed. It is still in depreciation mode in the eyes of most market participants, notwithstanding intervention by the PBOC and other parties.

Against this background, it seems clear that the need to stem depreciation pressure in the offshore market has taken a toll on China’s ambitions of internationalizing the yuan.

The usual measures of international yuan usage are all heading down.

The currency accounted for just 6.7% of total deposits in Hong Kong in August, barely half as much as in 2014. Cross-border settlement in yuan represented 21% of total trade logged in August, compared with 37% at the peak in March 2015. Issuance of offshore “dim sum” bonds denominated in yuan halved from 2014 to 2015.

These measures reflect investors’ doubts about the true value of the currency and the management of its movements, as even offshore investors get less and less say in deciding the yuan’s exchange rate.

This means that despite the symbolism of becoming an official SDR currency, the reality is that more will be needed for China to attract inflows and for the yuan to become a truly international currency. The perception of a currency as a dependable, strong store of value is essential to it becoming so, and that is exactly what the yuan is missing now.

It seems that a lot of fuss and rush has been created around China’s quest for SDR status. In the short run, China does not really seem ready to put up with the unintended consequences of becoming a reserve currency. It would have been much better for China to consolidate domestic and external financial reforms before applying for the yuan to become an SDR currency. The country could then be sure of attracting the interest of investors as a fully fledged reserve currency.

Alicia Garcia Herrero is a Senior Fellow at Bruegel and a non-resident research fellow at Real Instituto El Cano. She is also Chief Economist for Asia Pacific at NATIXIS. Alicia Garcia Herrero is currently adjunct professor at City University of Hong Kong and Hong Kong University of Science and Technology (HKUST) and visiting faculty at China-Europe International Business School (CEIBS).